Sterling rides on BOE hawks’ wings

In our Week Ahead article (posted before last Friday's US inflation shocker), the question was asked: ‘Can (the) BOE keep up with hawkish Fed and support GBPUSD?’

Today, we got our answer = yes … or, at least the BOE will try.

 

Let’s break down the latest policy decision by the Bank of England.
 

1. The BOE raised its bank rate by yet another 25 basis points – an outcome that was widely expected.
   
   The UK’s central bank has now hiked at 5 straight meetings, raising its benchmark rate by a cumulative 115 basis points since December.

REMINDER: Rate hikes are a central bank’s main weapon in trying to cool down inflation.

 

2. More importantly for markets, all 9 members of the BOE’s Monetary Policy Committee (the folks who vote on what to do as the central bank’s monetary policy) said that they will “act forcefully” if red-hot inflation sticks around for longer.
   
   Recall that UK inflation has already reached 9% in April, and is set to peak above 11% in October according to the BOE’s latest forecasts. That’s more than five times above the BOE’s 2% target!

NOTE: to "act forcefully" in the BOE's context = rate hikes that are larger than the usual 25-basis points in one go.
At least that's how markets interpreted it.

 

Such larger-than-usual hikes have become a global trend, given that soaring inflation is being felt worldwide.

For comparison, here’s what some major central banks have recently done:

• The Fed raised interest rates by 75 basis points just yesterday.
  That’s like firing 3 bullets in a single shot!
   
• The Swiss National Bank surprised markets today with a 50-bps hike – its first hike since 2007!
   
• Earlier this month, the Reserve Bank of Australia also shocked markets with a 50bps hike.

 

Back to the BOE …

Following today’s announcement, markets then fully priced in a 50-bps hike at the UK central bank’s next policy meeting in August.

Additionally, markets also now think that the BOE’s bank rate will hit 3% by December.

That’s sooner than previous forecasts that UK’s benchmark rate would only hit that round figure by February 2023.

 

Such ramped-up bets were enough to help GBPUSD erase most of its initial declines following today’s BOE announcement.

 

To be clear, this doesn’t mean things are looking up for the Pound from here on out.

Whether the Bank of England can actually deliver what the markets are aggressively pricing in - that's a separate matter.

 

Because, also today, the BOE issued a darker outlook for the UK economy.

• The economy (measured by GDP) is now forecasted to shrink by 0.3% this quarter (as opposed to the forecasted Q2 growth of 0.1% previously).
   
• Earlier this week, we learned that April's GDP had already contracted unexpectedly by 0.3% compared to March.
   
• Note also that the unemployment rate for the three months ending April has ticked back higher to 3.8% - the first rise in this unemployment gauge since December 2020.

 

Given such economic woes, the BOE could be forced to ease up on its rate hikes, and leave it lagging behind other major central banks.

 

Contrast the BOE’s stance to what the US Federal Reserve conveyed less than 24 hours ago.

The Fed could go with a second straight 75 bps hike in July if the US inflation data continues to stay at these painful levels.

And there are more US rate hikes set to come. A lot more.

After this week’s hike, US interest rates could go up from the current 1.75% to eventually peak at 3.8% by the end of next year. Markets think it would go even higher to 4%, with the Fed forced to keep raising until it can quell scorching hot US inflation that’s also at a four-decade high!

 

Overall, GBPUSD is set to continue reflecting the differences between the UK vs. US economies, and how well either can handle higher interest rates.

• The economy that’s closer to a recession should see its currency weaken.
   
• The central bank that can proceed with more rate hikes should see its currency strengthen.

 

On balance, this stronger US dollar environment is set to persist for a while more, keeping GBPUSD’s downtrend intact, barring a shockingly positive development out of the UK economy.

 

BoE Bank of England rate hikes GBPUSD Pound Sterling inflation